Mining Giants Face Reality Of Soft Global Demand

Includes: BHP, FXA, RIO, VALE
by: AlphaVN Research

Falling metal prices have caused more than $60 billion of write-downs of mineral assets. The tough environment is forcing the global mining giants to sell less lucrative assets of falling quality. BHP Billiton (NYSE:BHP) the world's biggest mining company and third leading iron-ore miner behind Vale (NYSE:VALE) and Rio Tinto (NYSE:RIO), is now planning to sell 10 assets as the company faces increasing debt and soft demand, particularly from China. Similarly Rio Tinto is looking to cut costs by $5 billion by the end of 2014 by putting assets up for sale. Thanks to a massive over-investiture during the last credit boom cycle these resource firms have little choice.

BHP Billiton reported a 14.1% drop in revenues to $32.20 billion in the second half of 2012 while EBIT dropped 38% to $9.78 billion. Lower commodity prices as well as the negative currency effects of both the Australian dollar and Chilean peso have hurt earnings. With the Aussie devaluing sharply in the past month after the RBA's rate cut this will mitigate some of those effects. The Aussie had been particularly strong, trading well above parity with the U.S. dollar but that has changed in recent weeks as the dollar rally is gaining steam thanks to suicidal Japanese monetary and fiscal policy. Similarly, Rio Tinto also saw a 46% slide in profits to $4.15 billion for the six months ending December 2012.

BHP's largest problem is its massive pile of debt. The strength of the company's balance sheet has changed dramatically from a healthy positive $200 million in net cash by the end of 2010 to a net debt of $30.4 billion by the end of last year. As a result of having to carry $25.1 billion in long-term debt, the company pays around $0.9 billion in annual interest expense. Similarly, Rio Tinto's gross debt has risen from $21.5 billion to $26.7 billion in just twelve months ending December 2012. Rio expanded its capital expenditure budget to a record of $17 billion in a macroeconomic environment that has all the signs of hitting the proverbial credit wall, which means lower commodity prices and lower cash flows for operations.

The graph below represents the iron-ore prices. Overall, the commodity's prices have fallen by 22% from January 2011 levels. The long term trend is negative which has created enormous problems for miners. The rally which began last fall with the Chinese stimulus package has ended as steel and steel feedstock prices within China have been soft all year. China's massive demand has attenuated and the steel market, in particular, will be undergoing a transformation during the next couple of years as regulatory requirements for steel mills are being liberalized and the sector is likely to go through a consolidation as private firms are freed to compete more equitably with state-owned enterprises. But, in the near term iron ore production is outstripping demand and prices are likely to remain, at best, range bound for the near term.

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Australia's iron ore output has risen dramatically over the years from a mere 80 million tons about ten years ago to the current 500 million tons as the country is one of the leading suppliers to China. Then, China slowed down as its economic growth fell from 10.4% in 2010 to 7.8% in 2012, causing a fall in demand and now, BHP, with its head office in Melbourne, is predicting "flattening" iron-ore demand from the country, which is consistent with what is seen within China's metals industry.

However, BHP is confident that in the long-term, five years, the company will be able to meet its targets as iron-ore growth would hit single-digit numbers. Rio is also future positive and is continuing with its plan to increase its output by 70 million tons each year until 2015 when it will be 360 million tons. The two companies are pinning their hopes on the increasing urbanization in China which increases the demand for steel.

Meanwhile, according to recent estimates, Rio and BHP could raise $10 billion and $25 billion respectively by selling their assets. This is going to fund the ambitious expansion plans and restructure debt.

Rio is planning to sell its 57% stake in Ivanhoe Australia, a copper and gold producer which is estimated to be worth around $157 million, which has dropped in value by nearly 90% from $1.49 billion in the beginning of 2011. Along with this, its 58% stake in Mongolian coal miner SouthGobi and 59% stake in Iron Ore Company of Canada could be also up for grabs. Some of its massive Australian coal, copper and gold projects are also being sold. Besides these, other gold, copper coal and uranium operations in Indonesia, Mozambique and Namibia and the U.S borate business could also be sold.

On other hand, BHP Billiton sold Pinto copper mine of Arizona for $650 million to Capstone Mining, which is significantly above the mid-point of its estimated value of $386 million. BHP also sold its shares for $1.6 billion in Western Australia's LNG project to PetroChina and diamond marketing operations for $500 million to Harry Winston. Besides these, a number of other assets from the nickel, thermal coal and aluminum mines in Australian and Brazilian to the oil fields in Pakistan could be sold in the near future.

It is clear that the coming years for Rio Tinto and BHP will witness sales of dozens of assets. It is also well known that Rio's former CEO Tom Albanese made some poorly timed acquisitions which caused more than $14 billion in write-downs. Similarly, BHP's former chief Marius Kloppers also stepped down earlier in February due to the debt concerns explained above. BHP is also implementing a management overhaul as three of the company's leading executives are being replaced. The company is in desperate need for change and it seems like the new CEO Andrew Mackenzie understands this perfectly.

Patience is required here, these firms have a lot of problems that need to be cleaned up before the market will reward them with higher prices. At this point, however, these stocks will have rallies sold and dips bought in longer-term consolidation trading while management cleans up the balance sheets.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.